Managed Futures Counter-Trend vs. Trend Following. Executive Briefing

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1 Managed Futures Counter-Trend vs. Trend Following Executive Briefing

2 Managed Futures Strategies The managed futures corner of the alternative investment space is one of the first places astute investors turn when they are seeking diversification from traditional asset classes. Spurred by the research of a Harvard professor in the early 1980 s that showed managed futures funds have low to negative correlations to equities and fixed income products, hedge funds and institutional investors have been utilizing managed futures strategies for years. Traditionally, managed futures strategies have been associated with commodity trading advisors (CTAs) using trend following systems to trade commodity futures contracts. However, there is also a niche of managed futures funds employing counter-trend trading models to trade a broad range of futures markets. Characteristics of Trend and Counter-Trend Trading Models Trend following is undoubtedly the most common trading system employed by managed futures funds. In general, a trend following system aims to invest in the direction of the long term trend of a commodity, interest rate, exchange rate, or equity index. A trend is considered the dominate direction of movement for a market over a specified timeframe. Trend following comes with a distinct statistical signature. For the most part, trend following systems trade infrequently, they have a low percentage of winning trades (25%-45%), and they have a high winning trade to losing trade ratio (usually greater than 2). Additionally, trend following systems tend to give back substantial profits at market turning points and they are subject to whipsaw in directionless markets. Counter-trend systems are far less common in managed futures strategies. Nevertheless, counter-trend models offer a systematic, reactionary framework for trading that is equally as effective as trend following, but completely opposite in methodology. Counter-trend systems generally have shorter duration trades, a higher percentage of winning trades, and a smaller win/loss ratio than their trend following counterparts. A typical counter-trend strategy will trade more frequently than a trend following strategy and produce 55% to 60% winning trades with a winning trade to losing trade ratio less than 1.5. The majority of counter-trend models are looking to sell short term overbought levels and buy short term oversold levels. This behavior allows counter-trend models to thrive in directionless/volatile markets and to react quickly to market turning points. The drawback of counter-trend models is that they often struggle in steady, trending environments. 2 Managed Futures Counter-Trend vs. Trend Following

3 Counter-Trend Models Within the Managed Futures Universe Counter trend trading strategies are gaining popularity, but they are still relatively rare in the Managed Futures Mutual Fund universe. It is difficult to estimate the amount of counter trend trading that is employed by managed futures mutual funds because many of the funds utilize more than one trading strategy. However, running a three factor regression model on the returns of the Managed Futures Mutual Fund universe does shed some light on the growth of counter trend strategies over the last 36 months. Using the Newedge Trend Index as a trend following factor, the Newedge Short-Term Traders Index as a short-term trading factor, and a simple 10 day high/low model as a counter trend factor well over 80% of historical managed futures mutual fund returns can be explained. Trend following strategies have, on average, explained the vast majority of the return series. Even still, the counter trend factor has become more prevalent over time, spiking in growth at the end of 2012 and explaining approximately 20% of the return series by the middle of Chart 1: Style Based Analysis of Funds in the Morningstar Open Ended Managed Futures Universe Asset Weighted Managed Futures Mutual Fund Composite Rolling 26 Week-Exposure 10 Day Hi/Low Counter-Trend Model NewEdge Trend Index R2 100% 75% 50% 25% 0% 6/24/11 9/9/11 11/25/11 2/10/12 4/27/12 7/13/12 9/28/12 12/14/12 3/1/13 5/17/13 8/2/13 10/18/13 1/3/14 3/21/14 6/6/14 3 Managed Futures Counter-Trend vs. Trend Following

4 Does Counter-Trend Trading Work? Over the past decade, Larry Connors and his research team at The Connors Group have published several studies highlighting the effectiveness of short-term, counter-trend strategies. The example below is an extrapolation of some of Mr. Connor s research. From December 31, 1993 to December 31, 2013 the S&P 500 returned %. Certainly, the market experienced some ravishing declines over that period, but if you managed to stay invested you received an annual rate of return of 9.13%. Bearing in mind the market s upward bias over this period, was it better to buy short term strength and sell short term weakness, or did buying weakness and selling strength (trading counter-trend) outperform over the last two decades? Intuition would suggest that buying short term strength and selling short term weakness (trading momentum) was more profitable; the trend is your friend right? To gauge the efficacy of buying short term strength and selling short term weakness, the S&P 500 was evaluated from the end of 1993 to the end of 2013 using a simple momentum model and a simple counter-trend model. 10 day highs and 10 days lows were used to encapsulate short term strength and weakness. If the S&P 500 made a new 10 day high, the momentum model went LONG on the close and held the position until the next trading day s close, trying to profit from the upward momentum of the market. Conversely, if the S&P 500 made a new 10 day low, the momentum model went SHORT on the close and held the position until the next trading day s close, trying to capitalize on the downward momentum of the market. The counter-trend model was exactly inverse the momentum model, going short on new 10 day highs and going long on new 10 day lows. The two models were also evaluated with 3 day, 5 day, and 10 day holding periods. Table 1 summarizes the results. Table 1: Short Term Momentum Model v. Short Term Counter-Trend Model on the S&P 500 from 12/31/1993 to 12/31/2013 S&P 500 Index 12/31/1993 to 12/31/2013 # Trading days 5038 Price Appreciation % Total Return % Momentum Holding Period 1 Day 3 Day 5 Day 10 Day # Trades % Winning 46.38% 34.95% 35.75% 32.96% Total Return % % % % Avg. Trade Return -0.10% -0.33% -0.43% -0.45% Std. Deviation 1.22% 2.35% 3.06% 3.79% t-stat p-value 99.98% 99.93% 99.70% 97.54% Counter-Trend Holding Period 1 Day 3 Day 5 Day 10 Day # Trades % Winning 53.51% 64.05% 63.16% 66.48% Total Return % % % % Avg. Trade Return 0.10% 0.30% 0.38% 0.39% Std. Deviation 1.22% 2.37% 3.07% 3.79% t-stat p-value 99.98% 99.78% 99.22% 95.00% 4 Managed Futures Counter-Trend vs. Trend Following

5 The results in Table 1 clearly show that trading counter-trend to the S&P 500 s short-term market extremes outperformed the simple momentum model. Furthermore, this simple counter-trend strategy performed in line with the total return of the S&P 500 Index (523.86% v %) even though it was only invested 37% of the time (1880 one day trades v trading days). Additionally, all four of the counter-trend s holding periods produced positive average trade returns that were statistically significant at a 95% confidence level. Sustainability and Benefits A strong case has been made for the efficacy of counter-trend trading, but the real question is why does a counter-trend approach work? The simplest answer is that day-to-day market movements are dominated by noise, fear, and greed. Over the short run, market participants are focused on their own investment timeframes and mandates. This includes managing operational functions, making decisions on how to allocate capital in and outside of the financial markets, and adhering to predefined investment rules. These peripheral agendas often do not align with the goal of maximizing returns and are therefore a major source of noise in the markets. Furthermore, investors are tasked with deciphering an endless stream of financial data. Humans are not adept at quickly discerning the optimal course of action given a complex set of facts and, consequently they fall back on more innate instincts like fear and greed in these situations. When this happens, they employ heuristics like buy strength, sell weakness or they panic into or out of a fast moving market. This behavior creates the short term price extremes that counter-trend models aim to exploit. Revisiting the simple 10 day high/low counter-trend model, it becomes clearer why trading short-term price revisions works. When the market reaches a 10 day high it is usually because a positive economic report, a stream of earnings surprises, or an interest rate cut has boosted prices higher over the past few days. On the day of the new high, the market looks strong and poised to move even higher. More than likely, however, investors have overreacted to the good news. Investors who wanted to buy already bought when the news was released, and now it is probable that the market will retrace as profit taking and short selling replace the exhausted buying pressure. Once investors ascertain that most of the bad news is already reflected in the market, they will discover they pushed prices too low in their panic to react quickly. Therefore, higher prices will follow over the short term, as the market corrects its mistake. Another strength of counter-trend strategies is the diversification benefit provided both at the total portfolio level and within a managed futures allocation. To illustrate the latter benefit, a comparison was created showing the correlation of a simple rules based counter-trend model (using a one day holding period) relative to the Newedge Trend Index. Table2: Correlation between Trend Following and Counter-Trend Model 1/3/2000 to 12/31/2013 Correlation (1/3/ /31/2013) S&P 500 Newedge Trend Index 10 Day Hi/Lo Counter-Trend Model S&P Newedge Trend Index Day Hi/Lo Counter-Trend Model The correlation between the trend following index and the counter-trend model was for the time period measured, thus the prospect of combining two non-correlated strategies provides investors with an effective diversification opportunity. 5 Managed Futures Counter-Trend vs. Trend Following

6 Summary While trend following has historically been the most common system employed by managed futures funds, there is a niche of funds employing counter-trend trading models that has been rising in popularity. Counter-trend models work because they are founded on the theory that markets are not efficient in the short run due to noise, fear, and greed. This inefficiency leads to a perpetual cycle of short term market extremes where prices wander too high or too low and then snap back to more reasonable levels as participants realize their mistakes. As such, they can effectively navigate and profit from short-term market overreactions and tend to be more consistent than trend following strategies. These models also tend to have a low correlation to traditional trend following systems, thereby providing a valuable diversification benefit. This material is prepared by 361 Capital, LLC and represents the views of the 361 Capital Investment Team. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. 1 The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds Dr. John Lintner. 2 Frequently Asked Questions About Managed Futures 3 Following the Trend Followers Managed Futures Today, May The Trend Isn t Your Only Friend Murray A. Ruggiero Jr., Futures Magazine, October % of the S&P 500 total return from 12/31/1993 to 12/31/2013 was attributable to dividends. 6 What Makes Your Brain Happy and Why You Should Do the Opposite, David DiSalvo. 7 Data gathered from Bloomberg. The Newedge Trend Index is comprised of equally weighted returns from a pool of trend following CTA s. The index data begins on January 3, Managed Futures Counter-Trend vs. Trend Following

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